Stock market and economic commentary November 21

“The hardest arithmetic to master is that which enables us to count our blessings.”

– Eric Hoffer, American philosopher and author.

Economic Update

At J.P. Morgan’s recent third quarter results presentation, Jamie Dimon, Chairman and CEO, was asked about comments he had made regarding the supply chain problems and what he had been hearing from around the world about the potential for log jams to open. This is what he said:

“I’m not hearing much different than you’re hearing. I know that the overfocus, over time is so extraordinary sometimes from the press that people forget the big picture. The economy is growing 4% or 5%. There’s not one company I know that’s not working aggressively to fix their supply chain issues. Sales are still up, credit card, debit card spend still up, consumers in great shape. And capitalism works. I doubt we’ll be talking about supply chain stuff in a year. I just think that we’re focusing on it too much. It’s simply dampening a fairly good economy; it’s not reversing a fairly good economy.”

Jamie Dimon has steered J.P. Morgan successfully through the ups and downs of economic and financial crises over the past 20 years and has made it the world’s biggest bank by market capitalisation. J.P. Morgan reported strong results and offered a first-hand look at what is going on in the US and global economy through its consumer and corporate lending businesses. The overriding message from Jamie Dimon was that it is important not to overfocus on short-term issues, something which we at Clarion say time and again.

We are in the midst of an extraordinary transition period, as the global economy attempts to enter a post-Covid-19 world. This period is characterised by strong economic recovery, voracious consumer demand for goods and services, resurgent industrial production and resource demand and extensive corporate investment in capacity and capabilities, but also by inherent volatility in the underlying economic data and capital markets.

Inflation remains a key concern for the markets. The recent 6.2% increase in the US Consumer Price Index, the highest reading in 30 years, reignited fears of the effects of rapid and unpredictable price pressures on the economy. And the US is not unique, as inflation numbers edge up across the global economy. Some of these increases reflect a normalisation of pricing for goods and services impacted by the pandemic, for example, airfares and energy. However, in recent months price increases have affected wider segments of the economy, namely logistics, the automotive industry, commodities and labour.

It is important to recall why these increases are happening. The global economy has faced significant disruption over the last three years, even before the pandemic began. Trade issues between the US and China had a significant impact on global trade flows and supply chains. This was followed by the pandemic-related shutdown of economic activity in the first half of 2020, followed by an unexpectedly rapid recovery and a shift in disposable spending from services to products.

It is therefore no surprise that ports, semiconductor production facilities and energy producers have been struggling to fully resume activities. Companies across the industrial spectrum are working hard to secure the required investments, while addressing a myriad of challenges. Similarly, we have seen a contraction in labour force participation and shortages in key logistical sectors, including road haulage and warehousing.

Some of the current changes in the labour market can be attributed to baby boomers who have reassessed their life priorities post pandemic and left the labour market, or people choosing professions with better working conditions. They are also related to complex social factors including access to childcare or general uncertainty regarding the evolution of the pandemic. Ultimately, these issues will prove transitory, and the global economy will readjust to more normalised levels of activity.

Only two months ago the Delta variant raged across the US, affecting job creation and raising concerns about the sustainability and pace of economic activity. Fortunately, these concerns proved to be short-lived, and the US economy has continued to grow and generate jobs. The latest news about the new Omicron variant found in South Africa is concerning because it seems to have mutations that make it more contagious and allow it to evade some of the vaccines. We have not seen evidence yet that it is more virulent in terms of serious cases, hospitalisations and deaths, and the hope is that it will follow the typical trajectory of viruses that mutate and become more contagious but less virulent.

So far, we have seen a great deal of resilience in economic activity, consumer demand and corporate spending. Consumers have continued to spend on discretionary purchases such as drinks, cosmetics and luxury goods. Businesses have increased their capital expenditure as economic activity gathers pace.

These investments in the infrastructure of tomorrow will be important drivers of growth for the years to come. They will enable a transition to a low carbon economy, improve energy generation and transmission, and increase factory automation among many other benefits. Ongoing digital transformation will cause businesses to continue to spend heavily to digitalise and to improve CRM systems, online marketing and e-commerce capabilities.

Recent US corporate results have been strong. By the middle of the month, S&P companies reported 18.8% revenue growth and 43.7% earnings growth on average. Although margin delivery has been good in aggregate, distribution has been uneven across the reporting universe. Companies with stronger pricing power or lower exposure to raw material or labour cost inflation have been better placed to withstand current inflationary pressures.

Our fund managers invest in many of those companies. Their pricing power and proven ability to adjust their cost base and size have meant that they have been able to pull all the levers at their disposal and to achieve higher profitability. As we look to next year, we expect this differentiation in performance to continue, as easy gains from economic recovery/value stocks subside and markets shift back to long-term secular growth, differentiated business models and strong track records of execution. This is a positive environment for our investment approach.

Stock Markets

Central banking, in the final analysis, isn’t usually very interesting. If central bankers are doing their job well and all else is well, then nobody should notice the largely technical decisions they take. Big surprises and battles between hawks and doves are often over-hyped narratives produced by the financial press.

But in recent years, more and more people have taken ever closer notice of what central bankers are up to. Their role and their power within the economy, and their accountability, has provoked anger both from the progressive left and the libertarian right. That, in turn, is because all is not well, for the reasons we know about, and monetary authorities have been delegated to act as firefighters. So, the job is more exciting than it used to be.

But every so often a central bank administers a bona fide surprise. That’s what the Bank of England did earlier this month by deciding to leave both interest rates and the quantitative easing programme unchanged, defying expectations of a rate rise when bond markets were priced on the assumption that an increase was a virtual certainty. As inflationary fears swept the world in September and October, the UK gilts market saw some of the most aggressive moves by bond investors betting that this would force a rate hike. Yields on two-year gilts shot up by some 25 basis points — and after the Bank’s decision to leave interest rates unchanged they came all the way back down again.

The Bank was unwilling to immediately raise interest rates as it expects GDP growth to be weaker in the third and fourth quarters of 2021 than it forecast in August, with growth actively regaining its pre-pandemic level only in the first three months of 2022. Equity investors responded positively pushing the UK stock market to a 20-month high.

The US Federal Reserve also managed to pull off the greatest trick in the central banking handbook by being boring. After its latest monetary policy setting meeting, it confirmed plans to start pulling back on its bond purchases (quantitative easing) by $15 billion each month, putting it on track to remove that leg of its stimulus completely by the middle of next year. The Fed also confirmed that despite inflationary pressures it was in no rush to raise interest rates, saying that it would be patient.

Fears of serious, durable inflation, aggressive central bank action and subsequent market chaos are still wildly premature. Central bankers and stock market investors now seem to accept that inflation, whilst accelerating, will ultimately settle back down to the low levels seen over the past few decades.

After all, the forces that have battered down inflation since the 1980s, such as globalisation, technology, demographics, debt burdens and the weakening bargaining power of labour, are unlikely to reverse.

Raising interest rates will not fix congested ports, logistical bottlenecks, selective labour shortages or under investment in energy infrastructure. But doing so prematurely could hamstring the economic recovery, and more so with a new wave of Covid 19 stalking parts of Europe and South Africa. So, the four central banks that matter: the Bank of England, the Federal Reserve Bank of America, the Bank of Japan and the European Central Bank are unlikely to slam the brakes on soon, even if inflation persists for a while longer.

A new monetary regime is starting but the reality is that it will probably look uncannily like the old one. The world economy is more vulnerable to, and intolerant of, interest rate rises than it used to be. The government debt ratio to GDP for developed economies has risen from 20% in the 1970s to over 100% now. Put simply, governments have become addicted to zero cost borrowing and cannot afford for it to increase. Interest rates are sure to rise at some point but only ever so gently and only in small steps. Negative real returns on cash and bonds are likely to persist for years to come.

All this left stock markets in the sweet spot they have occupied for most of the past year. After the inflation-induced jitters of September and October, stock markets recovered and began November flirting with all-time highs. But suddenly like a bolt from the blue, severe outbreaks of Covid 19 in parts of Europe and South Africa caused a return of short-term volatility on fears of the reimposition of lockdowns.

Investors were rattled by the growing concerns over a new and possibly vaccine-resistant coronavirus variant identified in South Africa, Botswana and Hong Kong. Travel-related stocks led the losses as Britain announced a temporary ban on flights from South Africa and several neighbouring countries, a move that was followed by Israel and Singapore, with the EU set to follow suit.

The B.1.1529 strain has been reported to contain up to 30 identified mutations, prompting officials from the World Health Organisation to call an emergency meeting to discuss what it means for vaccine efficacy as well as other treatments.

The Covid 19 pandemic is far from over and is following the path that some scientists and virologists predicted at the start. No one is safe until we are all safe and it could be three years from the onset of the pandemic before we will be able to finally declare victory over the Covid 19 enemy.

In the meantime, stock markets will be prone to swings in sentiment and bouts of volatility but given a world economy that is on the road to recovery and will not be blown off course, markets should still generate decent returns over the medium to long term.

A word about house prices:

The average price of a house in the UK recently hit a record high when passing the £265,000 mark and currently costs more than eight-times average earnings. This eight-times-earnings level has only been breached twice previously in the past 120 years – once just prior to the start of the financial crisis and once around the start of the 20th century.

It may only be of historic curiosity, but it is interesting that house prices were even more expensive in the latter half of the nineteenth century. They then went on a multi-decade downtrend relative to earnings. This only bottomed out after World War I. There were three important drivers of this: more houses, smaller houses, and rising incomes.

However, as house prices have risen from around four times average earnings in the mid-1990s to more than eight times more recently, affordability has deteriorated dramatically for first-time buyers (most mortgage providers apply constraints on the amount they will lend as a multiple of earnings). This has contributed to home ownership rates falling to 62-64% in the past five years, levels last seen in the early 1980s. Houses have rarely been more expensive relative to earnings than they are today in more than 120 years. Prices are stretched everywhere but London and the south of England stand out.

The last time there was a sustained decline in the house price-earnings multiple was the second half of the 19^th century. Average house prices fell for more than 50 years thanks to substantial building of houses, many of which were smaller than existed before. At the same time earnings rose.

Is property a better pension investment than shares?

A big shadow is the faith that many people put in property as their pension. Anyone who has read the Money section of a Sunday newspaper will be familiar with the question regularly posed to celebrity interviewees: Which is better, property or pension? In all but a tiny minority of cases, the answer comes back “property”.

House prices have tended to rise over time, so it is easy to understand why people say this. £100,000 worth of UK property 25 years ago would be worth an average of around £451,000 today. This obviously varies by region. In London it would be worth around £660,000 and in Scotland, £378,000. These figures exclude any costs of ownership such as maintenance, repairs, insurance or taxes; any income generated by the property (not relevant for primary residence, only buy-to-let); and the impact of leverage/mortgage finance.

However, that same £100,000 invested in the global stock market (again, excluding any costs) would have grown even more, to around £727,000. This is 10% more than in even the best performing regional property market, London. Furthermore, it doesn’t matter whether you look at this over 5, 10, 15-, 20-, 25- or 30-year horizons. The stock market would always have resulted in a bigger increase in your £100,000 compared with UK residential property. This also does not take into any account the substantial tax savings which can be earned by saving into a pension nor the substantial taxes and costs associated with buying and selling property.

So, the next time we think about which is better, property or pension, we should think carefully before we answer. Of course, we need to live somewhere; and property also offers a useful investment diversifier to stocks & shares.

And finally: The magic number of 72

This is a useful number to remember in mental arithmetic. Divide the annual rate of growth on your investments into 72 and the result is the number of years it will take for your investments to double in value. So, for instance, a 6% rate of growth means: 72 divided by 6 = 12. At this rate of growth, your money doubles in value every 12 years.

Conversely, if inflation averages 6% over the long term, the purchasing power of your capital and/or income will half every 12 years. Frightening!!

This will be the last issue of The Clarion before the coming Festive Season, so on behalf of the Directors and Staff at Clarion, I would like to take this opportunity to wish all our clients and business associates, families and friends, a very merry Christmas and a happy, successful and healthy 2022.

We thank you for your continued support and we look forward to updating you regularly throughout 2022. As always, please do get in touch if you have any questions.

Keith W Thompson

Clarion Group Chairman

November 2021

Creating better lives now and in the future for our clients, their families and those who are important to them.

Risk Warnings

Any investment performance figures referred to relate to past performance which is not a reliable indicator of future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments, and the income arising from them, can go down as well as up and is not guaranteed, which means that you may not get back what you invested. Unless indicated otherwise, performance figures are stated in British Pounds. Where performance figures are stated in other currencies, changes in exchange rates may also cause an investment to fluctuate in value.

Stock market and economic commentary November 2021